It's looking rather gloomy out there. The S&P 500 is down 13% year to date, led by the financial sector, which has lost more than a quarter of its value. Energy is down 16%, technology is down 18%; even the "best" sector of 2008 -- consumer staples -- is only up 1% year to date.
But there are two reasons why this is a great time to be invested in the market.
Add it up
Amid all of the doom and gloom, there's a little-known silver lining that hasn't been getting much attention.
Dividend yields are the highest they've been in years.
Twelve and a half years, to be precise. The recent market plunge has increased the dividend yield on the S&P 500 to 2.3%, its highest level since December 1995.
Not even during the aftermath of the tech-bubble collapse in the fall of 2002 -- when the S&P 500 traded at a paltry 815 -- did the yield break 2.0%.
The increased yield is even more impressive when you consider the following:
- 10% fewer companies paid dividends in 2007 than in 1995.
- Share buybacks have more than quadrupled since 2003.
- Companies are returning money to shareholders through other means, such as stock buybacks. The $589 billion spent in 2007 to buy back shares is more than double the $246 billion paid out in cash dividends the same year. For example, Procter & Gamble (NYSE: PG) repurchased $10 billion worth of stock over the last year, double the $4.5 billion it paid out in cash dividends.
- Financials, which have historically been the biggest dividend payers, making up 16% of the index but paying 25% of the dividends, have been cutting their payouts. Washington Mutual (NYSE: WM), a case in point, cut its quarterly dividend from $0.15 per share down to $0.01 per share.
Some of our best-known blue-chip stocks, including Pfizer (NYSE: PFE) and Citigroup (NYSE: C), currently sport yields in the 7% range, three times more than the S&P 500 average.
An unexpected disparity
But high dividend yields aren't the only reason this is a great time to be in the market -- stocks are also cheaper than trusty bonds.
The 10-year Treasury bond currently yields 3.6%. The equivalent measure of return for stocks is the earnings yield (earnings divided by price) -- and it currently stands at 5.8% for the S&P 500.
This divergence is unusual -- and it's a potential boon for investors. According to renowned value investor Arnold Van Den Berg of Century Management, whose firm returned 13% net of fees, versus 6% for the S&P 500 over the past 10 years:
The usual difference between a bond yield and stock earnings yield is about 1%. For example, if investors can get 6.3% on a guaranteed bond they are willing to accept 1% less, or a 5.3% earnings yield on a stock. The reason for this is that if you have a 5.3% stock earnings yield and it is growing at 7%, it will equal your 6.3% bond yield in about 3 years. Anytime thereafter, the stock earnings yield will increase by 7% per year.
Investors are usually willing to accept a lower yield in stocks, because of the presumption of future growth. Right now, however, investors can get that growth at a better price than bonds -- and with the bonus of high dividend yields.
Earnings yields like this suggest that the market thinks earnings are likely to fall. But I would counter that even if earnings fell, the S&P 500 still would yield an almost equal amount as Treasury bonds.
A good time to buy
The combination of high dividend and earnings yields relative to bond yields means that this is a great time to buy dividend stocks -- and they're solid bets for a bear market.
There are a lot of good options to research further. Cellular giant Vodafone (NYSE: VOD) is the world's biggest mobile-phone operator yet has fallen 40% off its highs -- its shares now yield more than 5%. U.S. communications behemoth Verizon (NYSE: VZ) yields better than 5%, too. Global consumer-goods heavyweight Unilever (NYSE: UN) yields 5.1% and should be relatively immune to financial-market turmoil. As my colleague Tim Hanson notes, dividend payers like these could save you from massive losses.
At Motley Fool Income Investor, we believe in the power of dividends to create unbeatable long-term returns. Our recommendations have an average dividend yield of 5.1% -- and an overall return of 13% compared with 7% for like amounts invested in the S&P 500.
Interested in adding a few dividend powerhouses to your portfolio? You can see all of our recommendations, as well as our best bets for new money now, with a 30-day free trial. Click here to get started.
This article was originally published on August 12, 2008. It has been updated.
Andrew Sullivan
loves dividends but has no financial position in any of the stocks mentioned in this article. Pfizer is a Motley Fool Income Investor and Inside Value recommendation. The Motley Fool has a disclosure policy.
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